Why There's Confusion Over Valuing Bitcoin

Bitcoin presents a new type of nontraditional, highly technical, experimental, and global digital instrument to our already complex world. That fact should not conjure fear. It should engender excitement.

When I caught wind of Bitcoin as a newly minted MBA in the summer of 2012, I immediately scoffed. At the time, one bitcoin was trading at around $10, with a total market cap of about $50 million, which I thought was outrageous. It was a new, unregulated, "imaginary" Internet currency. Even though I initially rejected the idea as utopian, it stuck with me for some time thereafter.

Fast forward to early 2013, when the European banking crisis was reaching a fever pitch and Cyprus was on the verge of the first modern bank "bail-in." As the bitcoin price began to rise rapidly on a daily basis, and the situation in Europe continued to deteriorate, I decided to remove my "I know everything" MBA grad cap for an "I know nothing" crypto dunce cap. And, boy, am I glad I did.

The more I read, watched, and listened to bitcoin experts attempt to explain the most confusing and thought-provoking advancement since the Internet, the more fascinated I became, not only with the idea of frictionless transactions, but also by the idea of stateless currency.

Given the complexity of bitcoin (economic, financial, political, ideological), there are many topics of discussion that deserve specific attention in their own right. The Digital Currency Council does an excellent job of providing an overview of these issues in its free courses. In today's piece, we will focus on one of my favorite, and most misunderstood, topics: bitcoin valuation.

Valuing bitcoin: A traditional perspective
First, I think it is important to give readers an idea of just how difficult it is to categorize bitcoin for valuation purposes. Unlike equities, bonds, and real estate, bitcoins create no cashflow. Most traditional financial analysis is based on terminally valuing an asset's or entity's discounted cashflows in order to determine a fair present value price for those future cashflows. In the case of equities, the earnings of a particular company that are distributed as dividends can be theoretically extended in perpetuity and discounted at current "risk-free" interest rates, thus creating what is knows as a discounted cashflow (DCF) valuation. Since bitcoin has no cashflow, this method of valuation is not useful.

With regard to stocks, thousands of companies in hundreds of industries provide a pool of potential comparables to value companies from a comparative and/or historical perspective. Again, there is only one bitcoin (and it is the first of its kind), so there is no use for this methodology, either. There are "altcoins," but they are not proper comps for bitcoin. (That is a topic for another day).

Moving to bonds or other interest-bearing instruments, they too provide steady and somewhat predictable cashflows due to the interest coupons that holders of the securities collect at set periods of time. Once again, we run into a problem with bitcoin due to the lack of regular cash payments, though this can be programmed into the blockchain as an added protocol layer. (Again, that is for another time.)

Lastly, real estate projects -- at least those purposed for investor profit and not for proprietor dwelling -- also produce steady cash revenue in the form of rents and homeowners' fees that act just as dividends and interest payments. No surprise that bitcoin cannot fit into this category, either, given its currency/commodity-like properties.

So the obvious question is still "What is the value of a bitcoin, and how do we derive it?"

Valuing bitcoin: A commodity perspective
The Austrian economist's answer to this question is "It's worth what someone else is willing to pay for it, and that value is derived from the individual's economic utility at any given point in time," but this is a little too philosophical for our purposes. However, it does provide a nice segue from viewing bitcoin as a traditional cashflow-producing asset to viewing it as a hybrid virtual commodity/currency, similar to gold and silver but without the physicality.

This approach makes sense, given the scarcity element, which is inherent in both metals and bitcoin, as well as the lack of counterparty risk when holding the assets directly (i.e., not with a bank, custodian, or exchange). For these reasons, bitcoin and precious metals are sometimes viewed as relative stores of value.

Unfortunately, this is where the similarities end. Gold is corporeal, and bitcoin is virtual. Gold is difficult and costly to store and transport. Bitcoin is free to store and cheaper than a nickel to send. Gold has been used to store and transmit value for thousands of years. Bitcoin has had a monetary value for less than five years. Finally, gold is not beholden to electricity or connectivity, while bitcoin fails if either of those goes down.

It is obvious that both gold and bitcoin have unique advantages and disadvantages, and both have a place in a diversified portfolio. However, this insight still does not give us a decent basis for valuing a single bitcoin, especially since we can't even determine the fair price for troy ounce of gold.

Does bitcoin have a fair value?
So does bitcoin have a fair value at all at this point in its infancy? Is price influenced by geography, demography, or politics? Are high transaction volumes and merchant adoption more important to sustainable success than hoarding? This early in the game, these questions are yet to be answered. However, the circumstances leave us with a once-in-a-lifetime opportunity to develop new academic and operational models based on real-time information from the bitcoin blockchain and ecosystem.

The problem is that the blockchain technology is so new that the academic and intellectual underpinnings to develop such models are still evolving on a daily basis. This is yet another opportunity to do good and make money.

As far as the actual bitcoin price, at this point the most effective and widely used method of valuation by cryptocurrency professionals is pure technical analysis (historical price/time data analysis) and correlation analysis (correlations to stocks, gold, fiat currencies). Though they are suboptimal, these methods still work well in an inefficient and illiquid market such as bitcoin, but they too will soon need to evolve.

Though bitcoin presents a new type of nontraditional, highly technical, experimental, and global digital instrument to our already complex world, that fact should not conjure fear. It should engender excitement. Those willing to jump down the rabbit hole will be greatly rewarded financially, intellectually, and ideologically for taking the dive into Bitcoinland. They also just might be making the world a better place.

Adam K. Wyatt is Chief Analyst and Editor at BullBearAnalytics, a division of Digital Currency Research LLC, an informational financial publishing firm focusing on digital currency trading, investing, and education. Adam graduated with a BA in Economics and Political Science ... View Full Bio